Question

Suppose John Doe rents his studio in Minnesota for his dancing school. He has to pay $2000 (the market rate) a month to rent his studio. Now suppose the state of Minnesota, as a gesture of their appreciation for John Doe’s contribution to society, decides to purchase the studio and give it back to John. He no longer has to pay rent for using the studio. Additionally assume nothing else changes and John continues to operate his dancing school. a. Has his accounting profit in each month changed after the gift? If so, what is the change? b. Has his economic profit changed after the gift? If so, what is the change?

Answer 1

a. Now John does not have to pay the rent he was paying earlier for using the land.Thus, total cost of production has fallen. This decline in the total cost of production will lead to increase in accounting profits which is given by the difference between Total Revenue and Total Cost. Thus, profits will increase by $2000.

b. Economic profits = Accounting Profit + Implicit cost of production.

Since Doe owns the land now, he can use the land for renting purposes or start other business and this will increase the opportunity cost and thus economic profits will increase but by a lesser amount as compared to the increase in accounting profits.